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Does High Debt Cause Slow Growth?

By Vikas Bajaj April 17, 2013 4:07 pmApril 17, 2013 4:07 pm

The debate over whether government spending hurts or helps growth has again taken center stage this week because of a new research paper by two professors and a graduate student at the University of Massachusetts at Amherst. Their study critiques the methods and conclusions of a 2010 paper by Kenneth Rogoff and Carmen Reinhart, both professors at Harvard, showing that countries with high debts also have lower growth rates.

The original paper is important because many Republicans as well as European policy makers cited it as evidence that if governments did not dramatically reduce debt they would consign their economies to years or decades of stagnation. Recall Mitt Romney’s admonition during the presidential debates that the United States was “heading towards Greece.”
The specific details of the debate have been covered extensively elsewhere, but broadly speaking the Amherst team – Thomas Herndon, Michael Ash and Robert Pollin – focused on whether Mr. Rogoff and Ms. Reinhart overstated the relationship between high government debt and economic growth because of incomplete data and questionable analytic methods. Mr. Rogoff and Ms. Reinhart said the average growth rates in countries with debts of more than 90 percent was –0.1 percent, but the Amherst team said it should have been 2.2 percent.

While it is important that economists get the numbers right, this debate has not really addressed the larger issue at stake here: the sequence of events. In other words, does high debt cause slow growth? Or does slow growth cause high debt? Or, to really complicate the discussion, do they both feed on each other depending on the specific circumstances of each country and how its policy makers respond?

Let’s just look at recent evidence. In the United States, the economy started slowing sharply in 2007 and 2008 because of the financial crisis, which let’s remember was caused by debts taken on by banks and the private sector, not the government. In fact, American government debt in 2008 was just 54 percent of GDP, according to International Monetary Fund data, comfortably below the 90 percent threshold cited in the Rogoff-Reinhart paper. Government debt has been climbing since, but most of the increase cannot be blamed on excessive spending; the fiscal stimulus package Congress approved in early 2009 amounted to less than 1 percent of GDP. So what has caused the surge in debt? The recession, mostly, which reduced government revenue by nearly 17 percent in 2009.

For more evidence questioning the idea that government debt causes growth to slow one can turn to Britain. In that country, Prime Minister David Cameron has been trying to cut spending and raise some taxes in an effort to bring down fiscal debt. Yet, far from achieving a lower debt, Britain’s debt as a percent of GDP has been growing, hitting 82.8 percent in 2012, up from 72.9 percent when Mr. Cameron took office. Why would that happen? The government’s effort to cut spending has served to depress rather than stimulate the economy, making it virtually impossible for the country to reduce its debt.

None of this is to say that governments can borrow and spend without a care. Eventually the United States and Britain, not to mention the rest of Europe, will have to pay down their debts. But real-world experience suggest that it’s counterproductive to try to reduce debts while the economy is still struggling.